Friday, April 9, 2010

"Debt Bomb Looms - Is a VAT in our Future?"

Sydney M. Williams

Thought of the Day
“Debt Bomb Looms – Is a VAT in our Future?”
April 9, 2010

Gregory Mankiw, Professor of Economics at Harvard and former Chairman of the Council of Economic Advisors under President Bush, wrote in the February 14, 2010 issue of the New York Times: “From 2005 to 2007…budget deficits…averaged less than 2% of GDP.” Those numbers were within the norm for the last forty years. An estimated $1.6 trillion deficit, forecast for 2010, would proximate 10.6% of GDP, the highest level since 1945 – and frighteningly close to Greece’s 12.8% deficit. (The previous post-War peak for the U.S. deficit, as a percent of the budget, was during Reagan’s defense build-up in the 1980s when it peaked at 5.03% in 1985.)

We know “a crisis being a terrible thing to waste” implied an excuse to expand the role of government and to add entitlements. The answer to the looming “debt bomb” will be taxes, not fiscal restraint. Income taxes will rise next year when the Bush cuts expire, but as Glenn Hubbard, Dean of Columbia Business School, wrote recently in the Wall Street Journal, “the top 1% pay well over one-third of federal income taxes.” The “rich” can and will, one is assured pay more, but serious deficit reductions will have to come from a broader tax source. Hence, the growing talk of a European style value-added tax.

There is one positive, in my opinion, to such a tax; it would serve to discourage consumption. But that only works if simultaneously taxes are lowered on investments. Discouraging consumption and encouraging investments are twin goals desirable for a healthy economic future. But the disadvantages of a V.A.T. are first, that it is regressive – it impacts the poor and middle class more than the wealthy. Second, it will depress economic growth and raise consumer prices.

The VAT was first introduced in France in 1954, initially directed at large businesses. Today, according to Wikipedia, it accounts for nearly 50% of French state revenues. The way it works is that it taxes the value added at each stage of production; so that, assuming a 15% VAT, a mine which sells ore to a smelter for a $1000 will charge his customer $1150. If the mine had bought tools valued at $200, they would have paid $230. The mine would then send the government a check for $120 – $150 less the $30 already paid. The process continues until a final product is sold to the consumer. Because of this process, it does not suffer the weakness of a typical sales tax, which, if deemed too high, is subject to avoidance, either by buying on-line or via another state. It has been called, fairly in my opinion, a stealth tax and today largely supports a significant portion of the social programs that have come to symbolize Western Europe.

“Everybody on the right seems convinced that a value-added tax is on its way,” wrote Ross Douthat in the April 7th issue of the New York Times. Assuming the statement is true, it may be a way of attempting to head off such an eventuality. But as early as last October, Nancy Pelosi said that a value-added tax was “on the table.”

No matter the tax rate, over the most of the post-War period, tax revenues averaged about 18.5% of GDP. When taxes rise, the wealthy shield their income and alter their behavior. During the same time, government spending as a percent of GDP has averaged about 20%. Today, spending is about 25% of GDP; expectations are that it will stay at that level for the foreseeable future – an expectation that seems reasonable given the bigger role for government Mr. Obama envisions. It will have to be paid for. Speaking recently at the New York Historical Society, former Fed Chairman Paul Volcker allegedly said: “If at the end of the day we need to raise taxes, we should raise taxes.” A VAT is appealing to Washington because a 10% tax would raise an estimated one trillion dollars.

However, in their book, How Capitalism Will Save Us, Steve Forbes and Elizabeth Ames refer to a value-added tax as , “insidious because it imposes an invisible layer of taxation that inflates the cost of living…increases the cost of doing business and hits all consumers.”

Gerald Seib, columnist for the Wall Street Journal, writes today: “There is a growing disconnect between the services Americans want and the taxes they are willing to pay.” In similar vein, Ross Douthat, writing recently in the New York Times, believes it unlikely that the government will be successful in passing a value-added tax (a middle class tax hike). However, should advocates for more government entitlements win the day, it seems to me such a tax may be in our future. And government will get even bigger and people will become more dependent – not an attractive outlook in my opinion.

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